Standard V(A) – Diligence and Reasonable Basis

V. Investment Analysis, Recommendations, and Action

Standard V outlines the responsibility of investment professionals regarding the performance of due diligence before making recommendations to clients.

Standard V(A)

Standard V(A) – Diligence and Reasonable Basis informs that recommendations be made based on a firm’s independent research or the quantitative research of other reputable sources.

Compliance

A reasonable basis is formed through the balanced use of quantitative study, third-party research, and company reports. Due diligence assumes a thorough study of numerous reputable sources of information before making recommendations.  The intent of Standard V(A) – Diligence and Reasonable Basis are to prevent conjecture in the form of a “hot tip.”

A partial list of examples of reasonable sources to be studied before making an investment recommendation include the following:

1. Global, regional, and national economic conditions
2. A company’s operating and financial history
3. Current conditions within an industry or sector.
4. Mutual funds’ fee structure and management history
5. Results and limitations of quantitative models
6. Quality of assets within a security
7. Fitness of chosen peer-group comparisons

When considering any source of research, it is necessary to consider limitations and assumptions made by the author and potential biases. For example, with the popularity of social media, it may be tempting to utilize investment blogs as research tools for making recommendations.  Even if a blogger is a CFA member, investment professionals are obliged to consider the limitations of references cited within a blog and the impact of incorporating this information on overall advice.

With regard to choosing an external advisor to manage certain asset classes or diversification strategies, the member must use reasonable care and diligence in choosing advisors. This includes reviewing external partners’ code of ethics and compliance procedures. It should also include a review of the quality of partners’ published information and its consistency of investment strategy.

Violation

To prevent a violation, firms should require that research reports, recommendations, and ratings have a basis that can be referenced as extensive and acceptable. This may be done by creating measurable parameters for establishing compliance with Standard V(A) – Diligence and Reasonable Basis.

Additionally, firms should have a policy for evaluating external advisors’ credentials before contracting with these partners.  A periodic review of the quality of the information provided by the firm will encourage the accuracy and thoroughness of the information provided over time.

Question

Michael Dade and Ron Gad, both CFA members, are financial advisors at Centerville Investments. Dade recommends that one of his clients buy Z-Co based on research conducted by his firm. Chavis recommends that one of her clients sell Z-Co based on research conducted by a different brokerage firm for general distribution.

Both recommendations are consistent with each client’s investment objectives and within the context of their entire portfolios. Neither Dade nor Gad has a reason to suspect that any information contained in the research reports from these two sources is inaccurate or inadequately supported. According to Standard V(A) – Diligence and Reasonable Basis, do Dade and Gad have a reasonable basis for making their investment recommendations?

A. Both of these advisors have a reasonable basis for their recommendations.

B. Only one of these advisors has a reasonable basis for his or her recommendation.

C. Neither of these advisors has a reasonable basis for their recommendations.

Solution

The correct answer is A.

Both Dade and Gad have practiced due diligence and made reasonable recommendations, in accordance with Standard V(A) – Diligence and Reasonable Basis so long as their reports are believed to be inclusive of accurate and adequate information, and investment recommendations are made in alliance with clients’ objectives.